GI Bill and Taxes….Not Exactly a Match Made in Heaven

Photo by scottchan

The Post-9/11 GI Bill is one of the best benefits out there today. The opportunity for a nearly “free” education is something you should take advantage of. But, like with many things the Post-9/11 GI Bill is not simple when it comes to taxes. Let me explain…

GI Bill Alone

First of all, all Veterans Administration (VA) benefits are tax-free. Good deal, right? It is. But the discussion doesn’t stop there. Your GI Bill benefits will all accrue to you tax free. No taxes, zip, nada. But guess what? If the GI Bill pays for your tuition and fees you can’t deduct tuition and fees on your taxes and you can’t claim the American Opportunity Credit. The one situation where you might be able to claim a deduction is if you go to a school where the GI Bill does NOT pay for all your qualified tuition and fees. In summary, Good: no taxes on income; Bad: no deductions if GI Bill pays the expenses.

GI Bill and Scholarships

We already know that the VA benefits are tax free. So what about scholarships? It depends. If the GI bill covers all qualified tuition and fees then any amount of scholarship that goes towards other college expenses (room and board, other non-qualified expenses) will be taxable income to the recipient. For example, assume that your child is going to college and you are using your GI Bill for the child’s education. If the child receives an academic award for $1,000 and that academic award is used for the college meal plan, your child has $1,000 in taxable income. Whether the child will actually owe taxes is another issue. A related issue applies to academic awards that have restrictions. If the student receives an award that can ONLY be used for tuition and fees, then your GI Bill benefit will be reduced. VA benefits are second to pay. So the tuition and fees would be fully funded, but in effect you would “lose” some of your earned benefits. These two situations may allow for some tax planning opportunities. For example, if you plan on using your GI Bill benefits to help your children you might want to steer more of your GI Bill towards a child who is less likely to receive academic awards. That way you will get the full value of the GI bill with the child who doesn’t get awards and maintain a tax write-off possibility with the child who receives scholarships. Of course, this could all change if there is a significant difference in tuition at the two schools. The bottom line is that if you are funding children’s education with GI Bill you want to plan how scholarships and tuition differences may affect your tax bill… not just split it in the middle.

GI Bill and 529 Plans

The combination of the GI Bill and 529 Plans gets even more complicated. The GI Bill can be used to pay for Tuition and Fees and the 529 plan can be used for other expenses. Qualified expenses for 529 plans are much broader than for deductions and credits. Proceeds from a 529 Plan can be used for (assuming the GI Bill paid for tuition and fees):

The purchase of computer technology, equipment, or Internet access and related services if it is to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is enrolled at an eligible educational institution. (This does not include expenses for computer software for sports, games, or hobbies unless

the software is predominantly educational in nature.)

Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible educational institution.

Expenses for room and board must be incurred by students who are enrolled at least half-time. The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts.

The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.

The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.

Proceeds, including earnings, from 529 Plans are tax-free if used for qualified expenses as defined above.

But, it doesn’t stop there. You must reduce your qualified expenses by the amount of tax-free benefits received. So…if the monthly BAH allowance covers the student’s room and board you would be limited to withdrawing funds only for computer equipment and special needs. If the BAH doesn’t fully cover room and board then you would be able to withdraw funds from the 529 Plan to cover the difference. You want to be careful here because the IRS doesn’t like it when you take funds out of a tax advantaged account for unauthorized uses. If you do so, you will pay taxes on the earning allocated to the overage plus a 10% tax penalty on those earnings as well.

GI Bill and Student Loans

Again, your GI Bill will pay for your tuition and fees and if you use student loans to pay for room and board you might be able to deduct the interest on the student loans. The caveat again is that you must first reduce the room and board expenses by the amount of BAH received. Then, the student will be able to deduct the interest on the amount of the loan used to fund the room and board above the BAH amount.

GI Bill and Yellow Ribbon Program

The Yellow Ribbon Program is where certain colleges agree to pay the difference in the GI Bill maximum amount payable and the actual tuition and fees. This will most likely occur when a student attends a private university or out-of-state university. While no college is required to pay the difference, if they chose to do so the payment would be treated, in my opinion, just like a scholarship used for tuition or fees. Therefore there would be no tax consequences.

So, there you have it. Not a Match Made in Heaven but the GI Bill is still a great benefit. I’m using mine now for my son and we have no complaints. You just need to make sure you understand the tax consequences.

Curt Sheldon is a Fee-Only Financial Planner based in Northern Virginia. He can be contacted at (703)542-4000 or Curt@CLSheldon.com

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication